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Ignoring Fundamentals: Speculation Has Been Driving Oil Prices

Crude Oil pipeline

2016 has been a roller coaster year for the oil traders. Markets had a near 100 percent rise from February lows, followed by a drop of more than 20 percent, which took the oil markets into a bear phase. However, the bear phase lasted only for a few days, as the markets again gained 20 percent.

Though part of the price action is due to fundamentals, the rest can be attributed to speculation.

The speculators in the oil markets feed on the rumors and fundamental news, and overshoot prices way above logical levels, trapping smaller investors.

This is not the first time we have seen speculation in oil prices.

Back in 2008, the vertical rise in crude oil was largely attributed to increased speculative activity.

(Click to enlarge)

The price of oil more than doubled from 2007 to 2008, when oil peaked at $147.27 a barrel in 2008. Analysts attributed the reasons for a rise to the Saudi’s not increasing production and increased demand, whereas the others pointed fingers towards the speculators.

During its investigation, the CFTC noted that 81 percent of all the oil contracts on the New York Mercantile Exchange was being traded by the large financial firms, speculating on behalf of their clients or themselves, reported The Washington Post back in August 2008.

The article also mentions that by the end of July 2008, one-third of all NYMEX oil contracts were held by just four swap dealers. The investment through swaps increased from a meager $13 billion in 2003 to a whopping $260 billion in 2008.

Back in June of 2008, the billionaire trader George Soros told the U.S. lawmakers that the institutional investors investing in the commodity indices were inflating a bubble.

Similarly, Ed Morse, who was with Lehman Brothers at that time opined: “As in the dotcom period, when ‘new economy’ stocks became popular, a growing number of Wall Street analysts have been repeatedly raising their forecasts as oil prices have risen,” said Mr. Morse: “These revised forecasts have been partially responsible for new investor flows, driving prices to perhaps unsustainable levels,” reported the Financial Times back in June 2008.

We all know what happened when the speculative bubble burst and positions had to be unwound, oil had a straight fall from the highs of $147.27 to $33.20 in a matter of seven months.

Thereafter, oil prices rose and remained in a range until 2014, when the fundamentals of the oil markets changed. With new supply in the markets, oil prices tanked from the highs of above $100 a barrel in 2014. Related: Is Doomsday Inevitable For Venezuela?

John Kemp of Reuters argues in his article that “there has been a close correspondence between hedge fund positions and the movement of oil prices since early 2014,” as shown in the chart below.

(Click to enlarge)

In February of this year, when oil prices hit record lows, the talks on a production freeze started the rally, as shown in the charts below.

(Click to enlarge)

Though most analysts agreed that a production freeze was not going to alter the fundamentals, prices rose sharply, with the hedge funds adding record long positions.

The Doha meeting ended without any resolution, as most had expected, but not before oil prices recovered to more than $42 a barrel without any change in fundamentals.

Similarly, oil prices touched a low of just below $40 a barrel in August on the back of a rising oil glut. Related: Could A Lithium Shortage De-Rail The Electric Car Boom?

Nonetheless, OPEC has again scheduled a meeting for discussing the production freeze, and oil prices responded accordingly, rising sharply in the last few days without any change in the underlying fundamentals. Analysts agree that even if production is frozen at current levels, it will not change the fundamentals.

“A freeze at 34 million barrels a day is not the same as one at 33 million barrels a day,” said David Hufton, chief executive of PVM Group in London, referring to the broker’s own estimate for total OPEC output. “It pushes the rebalancing process back at least a year,” reports Bloomberg.

But, it is important to note that the speculators don’t position themselves against the fundamentals. They aggravate the fall or extend the rally on the upside with their aggressive short or long positions.

Notwithstanding, prices have always returned back to their fundamental levels, albeit not before trapping unassuming investors on both sides of the trades. Oil was and will continue to be influenced by speculation.

By Rakesh Upadhyay for Oilpice.com

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Leave a comment
  • Kr55 on August 28 2016 said:
    Sounds like every publicly traded market, no?
  • Francis A Daley on August 29 2016 said:
    As far as that headline goes, "Well, duh"

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